Thursday, September 15, 2016

Is the Fed breaking the law by paying too much interest?

George Selgin had an interesting post describing how the Fed appears to be breaking the law by paying too much interest to reserve-holders. This is an idea that's cropped up on the blogosphere before, here is David Glasner, for instance.

I agree with George that the the letter of the law is being broken. That's unfortunate. As Section 19(b)(12)(A) of the Federal Reserve Act stipulates, the Fed can only pay interest "at a rate or rates not to exceed the general level of short-term interest rates." With three month treasury bills currently around 0.33% and the fed funds rate at 0.4%, the current interest rate on reserves (IOR) of 0.5% exceeds the legal maximum.

Unlike George, I don't think the Fed deserves criticism over this. If the letter of the law is being broken, the spirit of the law surely isn't.

If there is a spirit residing in the law governing IOR, it's the ghost of Milton Friedman. Since the Fed's inception in 1913, IOR had been effectively set at 0%, far below the general level of short term interest rates. This has acted as a tax on bankers. They have been forced to hold an asset—reserves—that provides a below-market return. Friedman's big idea was to remove this distortionary tax by bringing IOR up to the same level as other short term interest rates. Banks would now be earning the same rate as everyone else. The Fed would only get the authority to set a positive rate on reserves in 2008, long after most modern central banks like the Bank of Canada had implemented Friedman's idea.

Friedman wanted to remove the tax, but he didn't want to introduce a subsidy in its place. To prevent central bank subsidization of banks, the Federal Reserve Act is explicit that IOR should not exceed other short-term interest rates.

In practice, how might the Fed set IOR in a way that subsidizes banks? This is more complicated than it seems. If the Fed sets IOR at 1%, arbitrage dictates that all other short term rates will converge to that same level. After all, why would a financial institution buy a safe short term fixed income product for anything less than 1% if the central bank is fixing the yield of a competing product, reserves, at 1%?

Short-term yields won't converge exactly to IOR. Some will trade a hair above IOR, others a bit below. This is because each short-term fixed income product has its own set of peculiarities and these get built into their yield. For instance, buying federal funds is riskier than parking money at the Fed; in the latter transaction the Fed is your counterparty while in the former it's a bank, So the fed funds rate should trade a bit above IOR. But we wouldn't say that a higher fed funds rate is a sign of a below-market return on reserves, or that this spread represents an implicit tax on reserve owners. The fed funds rate exceeds IOR only because that is how the market has chosen to appraise the risk of owning fed funds.

Conversely, because a treasury bill is ofttimes less risky then parking money at the Fed, its yield should regularly dip below IOR. When it does, no one would say that the Fed is providing an unfair subsidy to reserve holders by paying IOR in excess of the treasury bill rate. The lower treasury bill rate is simply the free market's way of accounting for the superior risk profile of treasury bills relative to reserves.

Nowadays, with IOR at 0.5% and treasury bills yielding 0.33%, the Fed is clearly contradicting the wording of the Federal Reserve Act. IOR has been set at a rate that "exceeds the general level of short-term interest rates." But this by no means implies that the Fed is breaking the spirit of the law. The spirit of the law only tells the Fed not to pay subsidies to banks. As I explained above, the yield differential may simply reflect the market's assessment of the unique risks of various short-term fixed income products, not a policy of paying subsidies.

To get the ghost of Milton Friedman rolling in his grave, here is how to structure IOR so that it offers a subsidy to banks. The Fed would have to set up a tiered reserve system where a bank's first tier of reserves earns a higher rate than the next tier. To begin with, assume that Fed officials deem that a 0.5% fed funds rate is consistent with a 2% inflation target. The Fed offers to pays interest of 100% on required reserves (I'm exaggerating to make my point) while offering just 0.5% on excess reserves. Banks will hold required reserves up to the maximum and reap an incredibly 100% yearly return. All reserves above that ceiling will either be parked at the Fed to earn 0.5% or lent out in the fed funds market.

Thanks to arbitrage, the 0.5% rate on excess reserves ripples through to other short term rates. Because a bank can always leave excess reserves at the Fed and earn an easy 0.5%, a borrower will have to bid up the fed funds rate and t-bill rates to at least 0.5% in order to coax the marginal lender away from the Fed.

And that's how the Fed would subsidize banks. The "general level" of rates as implied by the rate on fed funds and treasury bills hovers at 0.5% while banks are earning a stunning 100% on a portion of their reserve holdings. It's highway robbery! Milton Friedman would be furious; the distortionary tax he so disliked has been replaced with a distortionary subsidy.

By the way, if you really want to know what tiering and central bank subsidies to banks look like, this is the exact same mechanism the Bank of Japan and Swiss National Bank have introduced to help banks deal with negative interest rates. See here and here.

So the bit of legalese that says that IOR should not exceed the "general level of short-term interest rates" is really just a poorly chosen set of words meant to describe a very specific idea, namely, a prohibition against setting a tiered reserve policy where the first tier, required reserves, earns more than the second, excess reserves, the ensuing subsidy flowing through to banks.

At the end of the day, what accounts for the current divergence between IOR and the other short term rates? Because the Fed has not set up a tiered reserve policy, there is simply no way that the divergence reflects a subsidization of banks. There is only one remaining explanation. Peculiar developments in the microstructure of the fed funds and t-bills markets have led traders to discount these rates relative to IOR.

So you can rest easy, Milton.

The peculiarities bedeviling the fed funds market are explained by Stephen Williamson here. There are several large entities, the GSEs, that can keep reserves at the Fed but are legally prevented from earning IOR. Anxious to get a better return, they invest in the fed funds market market, but only a limited number of banks have the balance sheet capacity to accept these funds. This oligopoly is able to extract a pound of flesh from the GSEs by lowballing the return they offer, the result being that the fed funds rate lies below IOR.

As for treasury bills, they are unique because, unlike reserves held at the Fed, they are accepted as collateral by a whole assortment of financial intermediaries. Put differently, treasury bills are a better money than reserves. Because the government is loath to issue too many of them, the supply of treasury bills has been kept artificially scarce so that they trade at a premium, a liquidity premium.

George ends his post by appealing to his readers to sue the Fed. I don't think think a lawsuit will bring much justice. If there are to be any legal battles to be fought, better to petition Congress to adjust the wording of the Federal Reserve Act so that it better fits the spirit of the law. We don't want the law to misidentify a situation involving IOR in excess of the "general level of interest rates" as necessarily implying subsidization when microstructure is actually at fault. While Milton Friedman had a lot of reasons to criticize the Fed, this probably wouldn't be one of them.

25 comments:

Great topic, JP. Even so, a Fed lawsuit is necessary, because if Bernanke is any guide, it's gonna happen. This plumbing is supposed to work in a negative-rate environment as well. They might discover a few complaints if the Fed reaches into bank capital to withdraw a negative IOR tax.

I've always been a bit dense how 0% IOR was a tax in the first place. The Federal Reserve system equity is self-owned by the banks, and membership is voluntary. It's much more akin to club "dues" than any similarity to what the IRS does. The moment banks decide that FRS costs exceed benefits, then they can leave. (I'm looking at you, negative rates.)

IOR could also create a bit of an incentive for the Fed region governors/banks to vote for higher IOR, i.e. claw back this *dreadful tax* from the Treasury. This IOR/general market level law might keep this incentive in check. Never seen a banker who did not respond to an incentive, JP.

Well, every US state has plenty of state chartered banks and credit unions. Nationally chartered banks require Fed membership. The 1980 act required state banks to hold reserves against deposits - so negative IOR could affect state bank required reserves. But being a nationally chartered bank holding billions of negative-yielding excess reserves could tempt a few to sell off assets & concentrate on state chartered activities; where they aren't required to hold excess reserves.

I am bothered by your entire framework but how can I explain my angst?

Perhaps we can look at the entire spectrum of bank deposit ownership, part of which becomes "reserves".

We easily see that banks have capital which is money they would have on deposit in their own bank. This money would be owned by bank investors.

We also easily see that depositors have placed their money into the bank, receiving an entry in a deposit record to memorialize the exchange.

These seem to be the only two sources for money existing in banks.

Now we look at what happens to money that has been placed into banks. Banks lend this money out by creating additional accounts of deposit and taking promises to repay in return. Here we see that banks are lending the money placed on deposit by original depositors. This results in multiple claims on the original deposits (each new loan ultimately results in two claims on the base deposit) setting up the possibility of future bank runs.

Reserves are simply the method used by the central bank to limit this sequence of lend-and-deposit. Reserves are sourced from money deposited by customers and the bank owners in the form of monetary capital.

Is this just "old school" thinking? Some would say so. Others would say this is the way banks really work. I might add that the prohibition against paying excessive interest on reserves makes lots of sense if "old school" thinking is the working theory.

Roger, all that may be true. But I don't see what it has to do with the point of the article, which is: the Fed may be breaking the letter of the law by setting IOR above the general level of market interest rates, but it isn't breaking the spirit of the law.

Well, I was bothered by the framework you seemed to use, part of which was that "spirit of the law" was derived from a proposal by Milton Friedman. I think you are correct in recognizing his proposal as a catalyst motivating the current wording in our banking law, but perhaps even his framework is suspicious.

How can I justify that suspicion? The demand for reserves is governmental rule, enforced by the governmental nature of the central bank. Following MMT theory, the central bank has no need to borrow because it can simply "print" the money. (This is done by CB-Treasury coordinated exchange of green-notes for bonds). The CB has no need to first acquire green-notes (such as forcing banks to deposit "reserves") for future lending to the Treasury.

If there is no need to borrow money, the CB has no reason to pay interest.

I suggested the use of the MMT framework. Maybe this is only my mechanical version of an MMT framework. In a mechanical construct, the creation of money also demands a method of destruction of money. In brief, money creation begins and ends at the Central Bank, preceding and underlying any money creation by not-central banks. In this mechanical MMT construction, both payoff-of-CB-held-Treasury-bonds and deposit-of-reserves-by not-central banks would destroy money, thereby reducing the available money supply.

You can see that using the mechanical MMT framework, there is no need for the CB to pay interest to the non-central banks. Under this framework, Friedman would be seen to be simply asking for a subsidy to the non-central banks.

Good question. If we assume that the CB has no need to pay IOR, and drops the rate to zero, what happens?

Well, where are we at right now? You were right when you wrote that IOR is 0.5% and the three month T-bill rate was 0.33%. Yesterday, the 3 month T-bill rate declined to 0.29%. Why would the T-bill rate be less than the interest rate on EXCESS reserves (0.5%) and the federal funds rate (0.5%)?

My speculation is that central banks and investors around the world see T-bills and other U.S. Government securities as the best EXCESS reserve investment possible if the Federal Reserve EXCESS reserve rate is unavailable to them. Simple competition has bid T-bills to these low interest rates.

If Federal Reserve IOR sets a rate for EXCESS reserves at 0.5% and limits participation in that pool, it limits the competition for T-bills. This should INCREASE the interest rates available in the U.S. and improve the strength of the dollar.

I notice that EXCESS reserves are about $2.2T in August and trending lower. I don't know what the trend might portend.

Concluding, I think that the general level of interest rates would be LOWER if IOR were set at zero. I also think that the growth of reserves would decrease by about 11 Billion per year if IOR was zero.

"...T-bills and other U.S. Government securities as the best EXCESS reserve investment possible if the Federal Reserve EXCESS reserve rate is unavailable to them."

Even if everyone in the world could hold reserves at the Fed, t-bill rates would still be below IOR. Because the marginal liquidity services of t-bills are valued more than those of reserves.

Milton Friedman did actually advocate your preferred policy; the reduction of short term interest rates to 0%. So I don't know why you're criticizing him. Friedman wanted to bring IOR up to the general level of interest rates or to bring the general level of interest rates down to IOR; they're the same thing in his world. What he wanted was to remove the gap.

The closest asset to reserves isn't t-bills, it's overnight repos. The repo rate should be lower than IOR, since reserves are strictly superior. It's not, so I conclude that banks are indeed being subsidized.

Besides, the "tax" argument only applies to required reserves. IOR on excess reserves ought to be below market, sufficient to cover the Fed's reserve related costs.

I think you missed my point. You can't take the yield differential between IOR and another short-term rate as an indication of a subsidy. By subsidy, I mean in the sense that Friedman described it, and in the sense that originally motivated lawmakers to give central banks permission to pay interest.

Repo is probably trading above IOR because of some sort of friction. Certainly not because of a tiered interest policy.

Suppose McDonalds decided, for no good reason, that it would stop buying Iowa beef and only buy Nebraska beef, and as a result Nebraska beef started trading at a premium to Iowa beef. Would you say "McDonalds isn't subsidizing Nebraska farmers. It's just some sort of friction."?

Nebraska beef won't trade at a premium because of the law of one price.

If a premium does develop, then it would be due to some friction, say some weird rules about moving beef across state. Or maybe scientists discover that Nebraska beef is inherently better after all, just like the market things t-bills are better than reserves. But we wouldn't blame this sort of price differential on McDonald's, just like we wouldn't blame the gap between IOR and t-bills on the Fed.

Since the Fed only needs to act rationally (fund itself at the lowest rate available) to remedy the problem, why not blame them? They can be excused for not foreseeing the problem, but not for letting it fester for 8 years.

If the Fed tries to reduce IOR to 0.38% in order to harvest the lowest rate available, the t-bill rate will just fall by 12 basis points to 0.26%. You can't catch your shadow.

The only way the Fed can fund themselves at the same level as government t-bills (0.38%) is by issuing t-bills themselves. And the more t-bills they issue, the faster that gap will shrink as the undersupply of safe government-issued bills is remedied.

But this just illustrates my point. Section 19 only prohibits situations in which IOR is directly responsible for the emergence of premium of IOR over the general level of short term rates. Right now, the Fed simply can't alter the current level of IOR to prevent a gap from emerging because IOR is not responsible for the premium.

Here's perhaps a simpler way of looking at it: if the Fed can borrow money overnight (from money market funds or anyone else who wants to participate) at a rate below IOR, obviously it should do so, without limit. It increases the Fed's profit with no downside.

The Fed in fact sets the "general level" either by controlling the quantity of excess reserves or paying interest on them.

The other rates arbitrage from that starting point - i.e. bills, the effect of GSEs on Fed Funds, etc.

The "general level" is therefore a range that is effectively determined by the Fed - the anchor for the range is what the Fed does with excess reserves.

The "letter of the law" only logically applies to a rate payable on required reserves - or as you say in some tiered arrangement that juxtaposes without interfering with the rate that the central bank uses to control the "general level".

It's all well and good to offer _theories_ according to which the Fed isn't breaking the law. The proof, though, is in the numbers themselves. The fact is that relevant short-term rates are below IOR. The one exception is the GC repo rate, but only owing to the recent quarter-end spike. Before that that rate was also below IOR by about 10 basis points.

George, imagine that legislators spend a long time debating, eventually deciding to pass a law saying "thou shall not kill." But in the printing process, it accidentally enters the constitution as "thou shall now kill." I think we can agree that the letter of the law would be ignored and judges would enforce the spirit of the law.

Holding the Fed to the interest rate wording in section 19 of the FR Act, as Hensarling and Heizinga do, would be like a lawmaker telling everyone to abide by the misspelled wording in the constitution and not its spirit. They would be forced to go out and slaughter their neighbors!